When the Covid-19 pandemic caused a precipitous drop in vehicle sales in spring 2020, automakers cut their orders of all parts and materials — including the chips needed for functions ranging from touchscreen displays to collision-avoidance systems. The pandemic has caused a swift and severe impact on the globally integrated automotive industry which was already grappling with a downturn in global demand.
In a short span of one tumultuous year, the Covid-19 pandemic has exposed deep crevices in the global semiconductor supply chain which hitherto virtually seemed immune and recession-proof.
Market indicators like delayed car sales or stockpiling of the new Playstation 5 point out the reality of us being in the midst of a global chip shortage. So, how exactly did we end up in this dire situation?
When the Covid-19 pandemic caused a precipitous drop in vehicle sales in spring 2020, automakers cut their orders of all parts and materials — including the chips needed for functions ranging from touchscreen displays to collision-avoidance systems. The pandemic has caused a swift and severe impact on the globally integrated automotive industry which was already grappling with a downturn in global demand. Symptoms like disruption in Chinese parts exports, large-scale manufacturing interruptions across Europe, and the closure of assembly plants in the United States may lead to increased merger & acquisition activity. Then, in the third quarter, when demand for passenger vehicles rebounded, chip manufacturers were already committed to supplying their big customers in consumer electronics and IT. Geopolitical factors also played a role, specifically when the Trump administration began tightly regulating sales of semiconductors to Huawei Technologies, ZTE, and other Chinese firms. Those companies began stockpiling chips essential to 5G smartphones and other products. At the same time, American firms were cut off from chips made by China’s Semiconductor Manufacturing International Corporation after the federal government blacklisted the firm. In July, a fire at a Japanese factory cut off supplies of special fiberglass used for printed circuit boards. Then, in October, a fire at a Japanese plant belonging to Asahi Kasei Microdevices took advanced sensing devices used in automotive and other industries out of circulation. As of late February, the plant was still down.
Nearly 7% of ocean freight is not making it out of China ports this quarter. Shortages of shipping containers resulted in companies having to pay premiums for shipping and drove demand towards airfreight. But the airfreight system has been experiencing higher demand due to global shipments of the Covid-19 vaccine even as its capacity has been reduced due to the pandemic-related drop in passenger travel, which has effectively meant that there are fewer passenger planes available to carry freight. In fact, global air-cargo capacity in the first quarter of 2021 is 25% less than last year.
The global semiconductor industry relies on high transnational divisions of labor stemming from the increasing complexity of chips and the economic pressure to innovate. In the late 1990s more than 20 companies operated 180 nanometer (nm) fabrication plants or “fabs,”; today only TSMC in Taiwan and Samsung in South Korea have the capabilities to successfully run cutting-edge 5 nm fabs.
To run a cutting-edge logic fab, companies need extensive process knowledge, close research collaborations with their suppliers, deep pockets to constantly invest in new equipment, and substantial government backing. These drivers explain why the number of firms operating cutting-edge logic fabs went from more than 20 to just two within two decades.
They also gave rise to the “fabless” business model – only designing chips and relying on contract foundries to manufacture them. Alibaba, Apple, Hisilicon, Tesla, and others all design their own chips but bank on TSMC as their contract chipmaker. TSMC is the largest contract chip maker in the world, with a market share of more than 55 percent. It is often the only viable option for chip design companies who want to develop cutting-edge logic chips – processors used in data centers, laptops, smartphones, automobiles, and military applications. TSMC’s dominance of advanced logic semiconductor manufacturing will most likely not change in a decade and perhaps longer, for several reasons.
The US and China are the two key players around which the semiconductor supply chain revolves. Being the two biggest customers, their needs are different in many ways. While most chips purchased from Taiwan/South Korea are for final product, a good part of Taiwan’s production is for American chip firms, such as Nvidia, where designers choose less expensive places to produce. Geopolitically, Trump dragged the chip industry into the middle of the US-China trade war and Pompeo re-recognized the Taiwan government. However, the Biden Administration will strengthen relations with South Korea and Taiwan, and likely use chips as leverage against China. In the Defence bill just passed, there was a provision for subsidizing US chip manufacturing and research, a counter to governmental subsidies in the Far East. The provision will be funded as there is bipartisan support, and it fits with Biden’s “build back better” program. But for now, in stark contrast with China, the US is comfortable with offshore production. For Beijing, semiconductor dependence is a “knife at China’s throat”. Improving domestic innovation and technology self-reliance are its two top policy priorities for 2021. Beyond this year, ambitious ‘China 2025’ targets still hold. The near-term focus is de-Americanisation of technology supply chains, entailing import substitution where possible, and order rerouting to East Asia if it is not. But cutting out US suppliers further increases PRC reliance on Taiwan and Korea. Such is the mainland dependence on Taiwan that Beijing is unwilling to apply economic pressure to the island. Instead, China has adopted “grey zone” warfare tactics, and even talked of military action, all the while continuing to purchase TSMC products.
Despite the growing prowess of Chinese technology firms in areas such as 5G, AI, mobile applications, and quantum computing, the country remains far behind the global cutting edge of semiconductor manufacturing. As a result, to meet Beijing’s ambitious goals for China’s technology and economic development and to remain globally competitive, domestic tech companies rely on overseas fabs to create their most advanced chips. China has been stepping up its push to master advanced semiconductor manufacturing. Through its massive National IC Investment Fund, established in 2014 and recapitalized in 2019, and other regional and local funds, China has earmarked funding in excess of $200 billion to move China up the manufacturing curve. Yet, it has so far achieved limited results. China’s leading fabrication company, Semiconductor Manufacturing International Corporation (SMIC), remains three to five years behind industry leaders Intel, Samsung, and TSMC.
Taiwan has now become the focal point of new US concerns about the semiconductor industry’s trajectory. US officials have also become uncomfortable with the growing presence of Chinese engineers at TSMC, which they view as increasing potential risks of IP theft or introduction of malicious hardware or software into US-bound supply chains. The US doubts Taiwan’s status as a safe haven for US IP—specifically, the potential for Chinese intelligence services to inject malicious code or hardware into advanced semiconductor designs.
As for China, any forced decoupling of Huawei or other Chinese companies from TSMC also carries the long term risk of higher geopolitical tensions across the Taiwan Strait. The status quo that governs the strait is partially dependent on economic ties, including the strategically important role that TSMC plays in supplying Huawei and other leading Chinese technology firms with cutting-edge semiconductors. Removing that ballast would push the relationship toward a more unstable place. Some Taiwan-based companies have already responded to President Tsai Ing-wen’s drive to reshore from the mainland to the island by moving some operations out of China. Military action over Taiwan regarding the semiconductor issue remains unlikely. Beijing and Washington will both attempt to avoid initiating a course of action that could lead to uncontrolled escalation between the world’s two leading military powers. That said, China has other options short of military action that it can use to try to gain leverage, including increased saber-rattling, nationalization of TSMC facilities in China, recruitment of key TSMC or Samsung personnel, IP theft, retaliatory actions against US and other Western technology firms operating in China, and greater investment in its domestic technology sector, including leveraging capital markets via the Hong Kong Stock Exchange or the new high-tech STAR market in Shanghai.
Thus, Taiwan and TSMC have taken on increased geopolitical importance in this environment- if the US broadens technology restrictions targeting semiconductors to other Chinese firms and succeeds in driving a wedge between China and Taiwan in the area of semiconductors, it would provoke a sharp response from Beijing, raising risks for global technology supply chains.
China’s advantages in this competition, including its STEM education system, dedicated industrial ministries, funding mechanisms, and market size will eventually produce breakthroughs, but the US will continue to hold key advantages and harbor a willingness to use punitive measures. If the US decides to further restrict semiconductor manufacturing equipment exports to China in addition to other measures such as the foreign direct product rule, China’s timeline for achieving greater self-sufficiency will be pushed further out. In any case, the global semiconductor industry will be in for a prolonged period of adjustment as the US-China-Taiwan triangle moves toward a new and hopefully more stable equilibrium.